Maybe Car Companies Don't Mind Shortages

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The automakers are getting comfortable in these lower volumes and not freaking out and having the extreme sense of urgency they would've had a year ago to find all the supply chain issues, solve them, and produce more and more and more because they're putting up record profits at these recession-level, you know, trough volumes.

Hello and welcome to the Barron's StreetWise Podcast. I'm Jack Howe. The voice you just heard is John Murphy. He's a car analyst at BofA Securities, and I'll talk in a moment about the stocks and supply and demand and why it's still so difficult to find a good deal on a vehicle. We'll also say a few words about the mighty US dollar. It's the strongest in two decades, you might have heard, but not everyone agrees. We'll look at what that means for investors. Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack.

You're going to be out next week. Do you want to tell folks why?

I'm getting married, Jack.

Getting married thousands of miles away from me, I might add. We won't say where, we won't say to whom, but I have had you both over to the house and a lovelier couple I have not seen. It's almost appalling, really. I wish you both the best of luck. Don't be surprised if there's a his and hers Baron Streetwise sweatshirt on the way to you just as a congratulations.

Is that one single sweatshirt or two sweatshirts?

I got to see what the budget will bear. Now it's early October, and when I walk outside and see leaves turning bright colors and I feel the crisp air, I think to myself, I wonder where auto inventory stood at the end of Q3. And I know what you're thinking, Jack, take a moment, look at something more beautiful than inventory reports. And you're right. Sales reports, not inventories, are the more important indicator of profits for the upcoming earnings season. I'll get to those too, but sales have been constrained by manufacturing bottlenecks since the start of the pandemic. Vehicle prices have shot higher. Now interest rates on car loans are up. You'd think that would hurt demand, but plenty of drivers have made do with older cars for longer, so You would also think that demand is pent up. So if inventories look fuller, it could help relieve price pressure. But if they look too full, it's a worrisome sign for the economy. Last week in this podcast, we talked about housing and how a spike in prices and mortgage rates have produced an affordability crisis in many markets, and how prices could come under pressure but seem unlikely to crash like they did 15 years ago because Millennials still need houses and supply is still so tight. The vehicle situation isn't quite that dire, but Edmunds, the car data service, pointed out something that I found remarkable this past week. More than 14% of Americans who financed a new car purchase during the third quarter signed up for monthly payments of over $1,000. That's up from 8% a year ago. For electric vehicles, the percentage is 26%. It's even higher for luxury nameplates like BMW and Mercedes, but also for pickup truck brands. Among Ford F-150 buyers who financed last quarter, 36% are paying over $1,000 a month. For Ram 1500 buyers, it's 29%. Now, I'm old-ish. I'm old enough, for example, to remember pay phones, including back before they went from a dime to a quarter. And a dime wasn't a fortune back then, but it was enough that a kid would check the coin returns to see if any had dimes in them, and once in a while one would. And if you don't know what I mean, it's too much to explain here, but basically America used to be filled with free slot machines that could also make phone calls. Now the point is, I'm aware of the possibility that some things only seem expensive to me because of my frame of reference, but $1,000 a month for a car feels like a lot. It feels like if you're well off enough to afford a vehicle that expensive, you should maybe also be well off enough to pay cash for it, unless we're talking about a vehicle that's necessary for a small business or something like that. And I'm not alone in feeling that way.

It does seem like that should not be a car payment. It feels like a rent payment, maybe not a mortgage payment in 2022, but perhaps a rent payment.

That's Jessica Caldwell. She's the executive director of insights at Edmunds. And she says payments have shot up with prices and finance rates, and because buyers are opting for bigger vehicles with lots of new technology, but also because more drivers are choosing to buy rather than lease. In 2019, before the pandemic, leasing was 30% of retail. This year, it's expected to be closer to 17%.

A lot of leasing, those monthly payments are because automakers are subsidizing either the interest rate of the lease or the residual. So that money that the vehicle is worth when you return it at the end of the 3 years, That's not happening as much. So people are looking at these lease numbers that are not subsidized, especially for serial leasers. A lot of people, once they start leasing, they don't get out of it. Every few years, they like having that new vehicle. Now all of a sudden you take it back and for the same vehicle, you're asked to pay hundreds of dollars more. That's not cool. I think a lot of consumers are definitely balking at that. So people are either buying out their lease or they're buying another vehicle altogether because at this point they might as well buy because leasing isn't necessarily giving them that much advantage.

Jessica mentioned residual values. Loan payments are higher than lease payments, all else held equal, because buyers pay for the whole car and leaseholders pay, as they say, for just the part they use. Lease payments are a function of the vehicle purchase price, the finance rate, and the residual value, or the amount that the vehicle is predicted to be worth at the end of the lease period. The key word there is predicted. The residual value is an educated guess. And think of how difficult it is for the dealer or manufacturer to make those guesses today. A shortage of new vehicles helped send used vehicle prices 56% higher in 2 years between the first pandemic summer and this past summer. Does that mean they're headed for a crash? We haven't seen one yet in consumer price data, but there's a wholesale index called the Manheim Used Vehicle Value Index, and it fell 3% in September from August. That might not sound like much, but it wouldn't take too many months like that to make a severe downturn or a return to normal or both. If you're setting lease terms, You do not want to get caught on the wrong end of that. It could cause big losses for the financing arms of car companies. And then think about the rate of technological change. I doubt very much that we'll go full robo-car by the end of the decade or that gasoline cars will be obsolete, but the trend toward autonomous electric vehicles seems fairly inevitable. And you don't have to get anywhere near close to full adoption to hit a tipping point for residual values. So lease makers have a lot of reasons to guess low on future used car prices, which is why they're coming in high on monthly lease payments, which is why more shoppers are buying rather than leasing, which is contributing to a rise in monthly payments. Okay, back to inventories. Across the industry, they're rising. B of A Securities says inventories in September hit 33 days worth of sales. That's up from 29 days in August and closer to 20 days a year ago. But Jessica at Edmunds says not to expect bargains. The X factor, she says, will be buyers who have put off purchases.

Intuitively, you would say, okay, demand is starting to soften, inventory is starting to build, it's time to get a good deal. But you've had people for over a year now sitting out of this market that are going to be start trickling in a little bit more because they have to, not because they necessarily want to. So I think anyone that is hearing this thinking, okay, great deals out there soon, that may not be the case.

To learn more about auto inventories, I checked in with John Murphy, who covers autos for BofA Securities.

It's certainly improved a little bit versus 3 or 4 months ago when we were about 1.1 million units on dealer lots. Last month we got up to a little bit over 1.2 million. And at the end of September, we ended at just over a little bit over 1.4 million units. So definitely a creep up here. So that is good for, for the consumer, maybe a little bit helpful on pricing. But in the context of history, inventory has traditionally been 3 million units plus. So we're still low in the grand scheme of the historical perspective. But definitely much improved versus 3 to 4 months ago.

I asked John when the supply of new cars will get back to normal, and I was surprised to hear him say not soon.

What we're hearing on the supply side is that there are still issues with semiconductors and production is relatively restrained, and there is almost no exact end in sight on that. And the important thing here is that the automakers are getting comfortable in their own skin and these lower volumes and not freaking out and having the extreme sense of urgency they would have had a year ago to find all the supply chain issues, solve them, and produce more and more and more because they're putting up record profits at these recession-level trough volumes, which is just fine from a financial perspective. So there's a kind of a real interesting dynamic here and that the automakers are finally starting to understand the Lagrangian profit maximization equation.

Ah, yes, the Lagrangian profit maximization equation. I remember it well from economics, probably. Jackson, as you know, I won a National Press Club Award this year for my Streetwise Investing column in Barron's Magazine. So I think I know what—

Isn't that specifically for humor? Humor writing, not economics.

Well, a win is a win. The important point about the whole Lagrangian framework is that, you see, lambda— you know what, let's let John sum it up.

If you produce too much at a lower price, it doesn't necessarily generate the most profits. And it's a really interesting test case after doing this for a few decades of seeing them finally being forced into that experiment, if you will.

That's interesting to me, and not just with respect to cars. Have you called an airline or other big company for customer service lately? I get messages that say, "We're experiencing longer than average hold time," and I think, "It's been longer than average for going on 3 years now. I think you might be confused about how averages work," or, "You can't find workers," or, "You're not paying enough," or the pandemic forced you to skimp on customer service and you were in no hurry to change back because this is more profitable. Maybe everyone out there is using that Lamborghini equation.

Lagrangian.

Right. And what if low auto inventories are only partly about the bottlenecks we've been talking about and are also partly about profit maximization? I noticed that light truck inventories in September at 36 days worth of sales were much higher than car inventories at 21 days. Trucks are much more profitable. Okay, that's supply. What happens from here with demand? John says the definition of demand right now is squishy, as he puts it. Demand used to be easy to figure out. Just look at the SAAR. S-A-A-R. That stands for seasonally adjusted annualized rate. And in the car business, It means you take last month's sales and then adjust for how good that month typically is each year relative to other months, and then multiply by 12 to get a year's worth of sales. It's more timely than actual sales for the past year, but it's also more theoretical. Cox Automotive, which owns the Kelley Blue Book pricing service, puts September's SAR at 13.3 million cars and light trucks. That's up from 12.3 million a year ago. But the reality is that raw monthly sales have been bouncing back and forth around 1.1 million vehicles since August of last year. And a SAR of 13 million is still way below the 17 million we were at before the pandemic. It's recession level. Put it this way, Cox had originally predicted that this year's sales would total 16 million vehicles. Then it cut its forecast to 15.3 million, then 14.4 million, and just recently to 13.7 million. If there were no vehicle shortages, estimating demand, as I said, would be as easy as looking at the SAR, 13 million and change. But everyone suspects there's extra demand that isn't being met right now. It just might not be that much, and that's what John means by squishy.

The risk is that as the Fed raises rates significantly, slows other parts of the economy, and maybe increases the cost of ownership with monthly payments and rates going up, they try to suppress demand to a level equal to supply or potentially below it to try to drive pricing down and help inflation. So that's the real significant risk at the moment is that we're relatively at recession-level volumes on fulfilled demand at the moment. And but the Fed wants to go even further.

John says that those falling used vehicle prices we mentioned earlier matter because until recently, some leaseholders had what the industry calls lease equity. That's where the payoff amount for the lease is lower than the current market value of the vehicle. And it's typically the result of the lease maker guessing too low on the residual values, which many obviously did before prices spiked. All that lease equity has helped shoppers to afford new vehicles, even with loan interest rates hitting 7% and higher. If used prices fall, however, that lease equity will go away. That could soften demand. Maybe then new vehicle prices will ease. For now, as Cox Automotive puts it, MSRP is the price. That's manufacturer's suggested retail price or sticker price. And it used to be the starting point for negotiating discounts, but these days discounts are slim. Although hopefully there will be fewer cases going forward of dealers charging big premiums to MSRP for new vehicles. Some makes are in better supply than others. Kia, Toyota, Subaru, and Honda recently had the fewest days' worth of supplies, while Jeep, Dodge, Ram, and Volvo had the most. As for the stocks, John recently published positive recommendations on some of the manufacturers like Ford and General Motors and some dealers like AutoNation. But he says that on an industry level, investors should look towards suppliers.

Automakers have generally been putting up record profits at trough volumes. Dealers have definitely been putting up record profits at trough volumes. But suppliers in the middle here have been getting clocked pretty hard because volume has just been so low and they don't have a pricing mechanism to pass on directly to their consumers, being the automakers, because they, you know, the automakers are just not accepting higher prices willy-nilly from the suppliers.

Suppliers might be struggling now, but as industry volumes improve, John says that gives them plenty of room for higher profits. He recently published positive recommendations there on Lear, ticker LEA. Aptiv, ticker APTV, and Magna International, that's MGA. Thank you, John and Jessica. I've spent so long on cars, I'll have to do some squeezing on the strong dollar, and squeeze I shall, right after this quick break.

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Welcome back. The US dollar received a brief but welcome beating this past week. It fell 1.5% on Tuesday alone, which is a big move for a currency. I say brief because it bounced right back, and I say welcome because the dollar's recent strength might be a bit of a problem for investors, but also an opportunity. That's the subject of this week's cover story in Barron's magazine. I'd invite the writer onto the podcast, but that guy is a rambler, right, Jackson?

I've gotten used to you by now.

Used to him. The dollar at one point was up close to 20% this year, and it hit a 20-year high, you might have heard. Both of those observations are the subject of debate, believe it or not. Welcome to currencies. We'll come back to that point in a moment. This matters for more than just currency traders.

Countries with, uh, currencies that are, let's say, 15% or more undervalued have had a tendency to outperform the average country by about 9 points over the next 3 years. The ones more expensive than average by about 15 or 16 have underperformed by 10 or 11% a year. So you do you see significant stock return differences.

That's Ben Inker, co-head of asset allocation at a money manager called GMO. And he has published a study of past performance for currencies that find that they've tended to mean revert. In other words, overvalued ones tend to become undervalued and vice versa. Not only that, stocks in overvalued currency countries tend to do poorly. And vice versa. And it seems related to earnings growth. Earnings tend to grow fastest where currencies are undervalued. That's not surprising. The strong US dollar makes exports for our big multinational companies more expensive for overseas buyers. On a related note, third quarter reporting season kicks off this coming week, and S&P 500 companies are seen reporting just 2.9% earnings growth. That's the slowest since the pandemic lockdown days of 2 years ago. You see where this is headed. Ben finds that the US dollar is 17% overvalued now. The euro, he says, is 17% undervalued. The yen is even cheaper, 20% undervalued. So Ben sees now is a good time to shift money from US stocks to Japan and Europe, especially Japan, because Europe faces a unique energy crisis from its recent dependence on Russian oil and gas. And the ongoing war in Ukraine. Let's come back to that. I said earlier that there's debate about even something as seemingly straightforward as how much the dollar is up this year. It's true, currencies are quoted relative to each other, and that raises the question of which ones to use. For the buck, there's something called the dollar index, which compares its price against 6 key currencies with the highest weightings overwhelmingly for the euro, British pound, and Japanese yen. Those have gotten clobbered, so it makes the dollar look like it's up a lot. But those currency weightings haven't changed since back when the euro was introduced. They bear little resemblance to where money is actually spent today. So the Federal Reserve instead watches a trade-weighted index that puts more emphasis on the currencies of China, Mexico, and Canada, and the US dollar isn't up nearly as much relative to those. In the Fed's view, in other words, the dollar isn't quite as strong as you've heard. That matters if you've been hoping that the Fed will get spooked by the dollar strength and halt its interest rate hikes. Don't count on it. Now here's one more point of debate: how to tell which currencies are overvalued and undervalued. There's a common method called purchasing power parity that involves comparing price differences with exchange rates. There's just one problem with it.

The problem with purchasing power parity is that currencies tend to spend most of the time trading very far away from it.

Currencies spend most of their time trading very far away from purchasing power parity. That's Vasily Sarabrennikov, a macro and currency exchange strategist at UBS. And he has a better method for currency valuation that involves starting with purchasing power parity and then adjusting it for factors that are known to affect currency demand. For example, there's the fact that the US, unlike Europe and Japan, has become a net energy exporter at a time when energy prices have spiked. Here's Vassily.

We certainly think the dollar is expensive, but the notion that it's extreme or somehow misaligned with some of these fundamental drivers, we don't buy into that. We think it's consistent with, with those factors driving it higher.

By Vassili's math, the dollar is only around 12% overpriced, and that's 5 points lower than the high point 2 decades ago. Other firms, including Goldman Sachs this past week, have predicted that the dollar could move modestly higher from here. So don't make big bets on the buck. But that doesn't diminish Ben's point at GMO. He's not trying to call a top. He's just saying to consider shifting a bit from the US to overseas. US stocks are around 60% of the world stock market, which is high. If you're even higher, maybe buy a low-cost Japan or Eurozone index fund. You don't have to think of it as a currency tactic. Shares in both markets are significantly cheaper relative to U.S. shares on earnings, and they come with bigger dividend yields. You basically get a double discount— the shares and the currencies. Thank you, John and Jessica and Ben and Vasily, and thank all of you for listening. Jackson Wedding Bells Cantrell is our producer. Jackson, I wish you joy and peace and a favorable exchange rate when you get to your honeymoon in Europe.

That's so sweet of you.

Subscribe to the podcast, rate it, review it, share your thoughts on Twitter. That's @jackhowgh. See you next week.

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